The Case for a Separate, Lower Capital Gains Tax Rate

"The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital . . . the ease or difficulty experienced by new ventures in obtaining capital, and thereby the strength and potential for growth in the economy."
— President John F. Kennedy, 1963

In the 2012 presidential debate against Mitt Romney, President Obama was asked to defend his policy of increasing the long-term capital gains tax. President Obama responded, “It’s only fair.”Obama’s appeal to fairness has widespread appeal among the American public. Critics argue that keeping the long-term capital gains (LTCG) rate separate and lower than the normal income tax rate is a regressive tax break for the wealthy, who primarily derive their income from capital gains on their investments. It strikes us as unjust when Warren Buffet claims that he pays a lower effective tax rate than his secretary.

However, myopic egalitarianism on the issue of taxes would have ruinous consequences for every stratum of our society. Long-term investments deserve a special status in the federal tax code because the incentive structures that determine how we allocate capital determine how dynamic our economy is, and what opportunities are available for working and middle-class Americans.

A separate, lower LTCG tax encourages skilled investors to reallocate capital to the most promising projects, ensuring that capital moves to the companies most likely to create jobs and prosperity as they innovate and scale. Over time, better investment of capital literally means higher wages for workers, superior goods for consumers, and a more sustainable tax base.

Critics often overlook the fact that the maximum federal LTCG rate in the United States — 23.8% — is one of the highest in the developed world.[1] And our capital gains rate stands in stark contrast to Singapore, Hong Kong, and a dozen OECD countries, which have no capital gains taxes at all.

The reason industrialized countries prefer a separate, lower capital gains rate (or none) is that raising LTCG to the level of the income tax would freeze long-term investments in place. Economists call this capital ice age phenomenon the “lock-in effect”. When the capital gains rate is high, the tax penalty discourages investors from moving their money to exciting, high-growth investments. Consider the following example:

Scenario 1

Suppose Ms. Savvybucks has grown a very small investment into $10M in an asset that she now expects to return about 10% annually. She would like to shift the $10M into an asset that seems likely to return 20% year over year.

In a world with Bernie Sanders’ proposed tax rate of 63.8%, she would have to take an enormous haircut and start over in the new asset with a base investment of $3.62M. Investing $3.62M at the new compounding rate of 20%, it would take her 11.6 years to make up for the massive cut necessary to shift her money into the higher-performing asset. So on any ordinary time frame it’s more reasonable for her to remain “locked-in” to her original, now lower-performing investment.[2]

Scenario 2

‍In a world with the actual current tax rate of 23.8%, Ms. Savvybucks would take a hit of $2.38M and start her investment in the second, higher-performing asset with $7.62M. In this world, it would only take her about 3.2 years to overtake her original investment, making it more likely that she does so.[3]

The lower the capital gains tax, the more our capital allocation is aligned with higher growth. To drive the point home, consider that over the 11.6 year time frame that would have justified shifting to the more productive investment in Bernie’s capital market dystopia she would have made $63.2M[4] — with all the upside in wages and prosperity that implies for society!

Only somebody who doesn’t really believe in the positive benefits of our market system, and the hard work Ms. Savvybucks and millions of others do as investors could argue for a capital gains rate as high as Bernie proposes.

Several empirical studies vindicate the conclusion that high capital gains tax rates create a lock-in effect and cripple growth in the real economy.[5] A Harvard study found that a 10.0 percentage-point increase in the marginal tax rate reduced the probability of selling a stock by a full 6.5 percentage points.[6] Another study concluded that eliminating capital gains taxes wholesale could increase GDP by 1% to 3%.[7] Interestingly, historical evidence suggests that a lower capital gains tax rate often improves economic growth such that it increases net tax revenue.

We need better, smarter government which addresses healthcare needs, education, infrastructure, cost of living barriers, and other challenges which prevent the least well-off Americans from accessing real opportunities. A knee-jerk response to structural inequalities in our society is to resent wealthy Americans and demand massive redistributive taxation. We must reject this politics of envy. Our tax system should be designed in such a way that it pays for the government we need without corroding the market incentives that have enabled American prosperity in the first place.

Explosive, sustainable economic growth is only possible in a society where the best ideas win. Just as workers should be free to leave their jobs in pursuit of more fruitful careers and entrepreneurs to devote their energy to whichever causes inspire them, investors must be free to reallocate their funds to the most compelling projects and assets in the economy.

Those who are already wealthy and have their money parked in large companies they don’t plan to sell might like high capital gains taxes. After all, higher taxes prevent investors from reallocating their capital out of the old, slower-growing businesses and into new up-and-coming entrepreneurs who are apt to disrupt incumbents! But America should not defer to the established versus the new.

Our market system works best for all of society — not merely the financial elite — when it rewards investors who allocate capital within a long-term framework to enable growth. Rather than trapping investors and lowering growth, we should embrace the principle of choice and cultivate a more dynamic investment ecosystem. A separate, lower capital gains tax rate is one obvious way to maintain the conditions of economic progress that allow our society to create opportunities for Americans of all walks of life.

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Appendix

[1] Pomerleau, Kyle. “U.S. Taxpayers Face the 6th Highest Top Marginal Capital Gains Tax Rate in the OECD.” Tax Foundation, Tax Foundation, March 24, 2015.

[2] $3.62M compounding at a rate of 20% annually for 11.6 years = $30,006,201.73. $10M compounding at a rate of 10% annually for 11.6 years = $29,923,740.46.

[3] $7.62M compounding at a rate of 20% annually for 3.2 years = $13,656,360.06. $10M compounding at a rate of 10% annually for 3.2 years = $13,566,149.31

[4] $7.62M compounding at a rate of 20% annually for 11.6 years = $63,162,225.74.

[5] Many studies provide empirical evidence of the existence of a lock-in effect. For instance, see Bolster, Lindsey, and Mitrusi (1989), Jog (1995) Landsman and Shackelford, 1995, Shackelford, 2000, Blouin et al., 2000, and Dai et al., 2006 for empirical evidence of the lock-in effect.

[6] In an earlier study, Yitzhaki (1979) estimates that high-income investors sacrifice an annual return of approximately 1.5% of the value of their stock as a result of the lock-in effect.

[7] Clemens, Jason, Charles Lammam, and Matthew Lo. “The Economic Costs of Capital Gains Taxes in Canada.” Fraser Institute, October 2014.